The RBI weekly inflation figures are out, and inflation in India is pretty much around what it was last week. So prices continue to rise at a steady rate despite rapid decreases in interests which have pumped crores of Rupees into the economy.

How do we explain the puzzle. For one there is a time lag, this is a boring and well know explanation. A more interesting one is what may be called the “velocity of money”, though a term greatly misused by Keynesians, it did at some point have a simple meaning. The term is pretty old, Henry Thorton mentions it in his 1802 book on Paper Credit in Great Britain, and thats not the first instance I believe.

Velocity of money is the rate at which notes circulate, or change hands. So velocity can be something like a 10 Rupee note on the average changes hands every 10 minutes, for example.

Now say I get paid on a daily basis and usually exchange 50% of my notes for goods, so if I have 100, I spend 50. But when a recession breaks out people get a bit uncertain about their future income, they increase savings to be on the safer side of things. I like other good men reduce my spending to 25% of my holding. In other words the velocity of money is fallen, the same notes don’t circulate as much, they are hoarded as savings.

The Keynesian prescription then can take many forms. One of them is to send people checks, so if velocity of money is fallen, lets increase monetary incomes. I get a check of 100, my income is now 200, I spend 25%, which is 50. So monetary demand is maintained. Let me for the movement leave out the other diastorous consequences this kind of thinking can have, and just focus on inflation.

Now if the monetary fillip is less than decrease in velocity due to “fall in credit worthiness” and “fear”, then there maybe deflation or reduced inflation in the very short run. In otherwords, if the check is recieve is of 50 only, my income become 150, and I spend 25% which is 37.5 (less than the earlier 50). Monetary demand falls, so inflationary pressures fall.

But soon, as the economy gets itself rolling, people begin spending the money. Velocity of money goes back to earlier rates, plus now there is more money in the system, so you get rapid inflation, and more trouble! And if the government tires to pull the money out, say higher interests, then you get into all sorts of mess like some investment projects not being profitable anymore, etcetera.

So when does government printing of money lead to hyperinflation. Well typically the richer guys hedge themselves, in otherwords they don’t hold their wealth in government money. The poorer ones do, either directly in cash holding or in assets which are not marked to inflation. Usually, the middle class and poor find it too expensive to gather the knowledge or other resources necessary for hedging. But once the printing goes beyond a level during recession, almost everyone figures that though we must save to help tide over possible hardships, they cant save in government money since its becoming worthless. At this point the velocity of money shoots up exponentially, people want to get rid of government notes in minutes. And naturally high velocity combined with more money leads to hyperinflation.

So thats the story my friends, at least the way I see. Do let me know what you think. Also check out W H Hutt s Keynesianism: Retrospect and Prospect, a good read in these troubled times. I have just began.

Related posts:

1. M0 Money, M0 Problems: Expect Massive Inflation in 2009 and Beyond
2. Inflation, Deflation, Recession
3. Inflation With Gary North Or Deflation With Mish
4. The Distortionary Effects of Monetary Inflation
5. Hyperinflation: The Inevitable Result of Government-Manged Money